The S corporation is a popular option of tax classification for business owners.  As a pass-through entity S corporations are subject to a single layer of tax. In addition, the earnings and owner distributions are not subject to Social Security or Medicare taxes.  These are attractive prospects for owners looking to improve cashflow.  However, there are some key issues that can be overlooked when establishing and operating an S corporation.  

Ownership Restrictions

Probably the most well-known restrictions on S corporations are the limits on ownership structure.

1. An S corporation is limited to no more than 100 shareholders.
2. It is limited to certain types of shareholders. Only U.S. citizens or residents in their capacity as individuals, certain trusts, estates, and certain exempt organizations are allowed.
3. It is also limited to issuing one class of stock with regards to rights to distributions. When distributing to its owners, the distributions must be made based on their ownership percentages (pro-rata).

Reasonable Compensation

For many the main attraction of the S corporation is the opportunity to reduce self-employment taxes.  However, it is important to remember that if an owner in an S corporation provides services beyond the capacity as an investor they are required to receive “reasonable compensation.” 

The definition of “reasonable compensation” has been an area of abuse and sometimes dispute in audits.  In general, they want an owner to receive the same compensation that an unrelated third party would demand for a similar role.  The definition is not clear.

Since this is a subjective concept, owners should document and justify their compensation levels as best they can.  It should include an evaluation of quantitative and qualitative factors based on their facts and circumstances.  Here are a few factors to consider when setting reasonable compensation:

• Industry standards
• Job duties of the owner
• Qualifications of the owner
• Number of other employees and their duties
• Location
• Profitability of the company
• Reasonable return as an investor

If owners have doubts about the reasonableness of their compensation, or are not taking a salary at all, they should consult with their tax advisor to evaluate these factors.

Debt Basis

An owner’s “basis” is an important tax concept for pass-through entities. It can determine the tax-free status of distributions and the deductibility of losses.  As a tax concept it can be somewhat arbitrary in its definition.  A key distinction to remember regarding S corporations is that their owners cannot recognize any basis from third party debt to the entity.  An S corporation only counts the amount loaned to the corporation directly from the shareholder.  

Loans between the company and the owner should be formally documented with appropriate terms for interest and repayment.  Tax basis and loan documentation are complex concepts. Owners should consult with their legal and tax advisors. 

Distributions of Property

Another pitfall of S corporations is with regards to the distribution of non-cash property.  When an S corporation distributes property to an owner it can trigger taxable gain if the property has increased in value.  Even property that has not increased in value can trigger tax if the corporation has claimed a depreciation deduction for the property. 

Red Tape

It is important to remember that any separate entity structure comes with added compliance requirements.  This is especially true with the corporate structure.

Requirements will vary by jurisdiction and entity but a few items to remember are:

• Additional tax filings
• Corporate minutes
• Routine board meetings
• Bylaws
• Shareholder/Member agreements

It is also important to maintain financial separation of the owners and the company.  The company should not pay personal expenses directly.  Instead, owners should determine their personal budgets and assess the company’s cash flow to establish routine payments of compensation and distributions to support their lifestyle.  This separation helps maintain the validity of the entity for legal, as well as tax purposes.  Failure to respect the company as a separate entity can undermine liability protections.

Selecting and operating an entity structure is a complicated process that can have unforeseen consequences for the unprepared.  Enterprising business owners should consult with their legal and financial advisors to make informed decisions.  Please contact your Dermody, Burke & Brown advisor if you would like to discuss further.